Get Ahead of Uncle Sam

When the ball drops in Times Square on midnight, January 1, 2018, the old year is over. This means your tax bill is due and there is little you can do at that point to lower the bill. You can make contributions to retirement accounts and take a few other actions after the first, but you have few choices then.

Now, you have time to plan, and more importantly you have time to act. There are a number of actions you can take to help preserve gains, potentially defer taxes and possibly even reduce taxes. However, we are not tax advisers and we urge you to consult with a qualified professional to discuss your personal circumstances.

As many investors know, stocks have been in a strong up trend for most of 2017. This has led to large gains for many investors. This might not be a problem for investors in retirement accounts which enjoy tax advantages. However, in taxable accounts, gains can lead to tax bills.

Investors who lock in a profit on a position by selling can create a taxable capital gain. The taxes are due when annual income taxes are due, quarterly for some tax payers and annually for others. A capital loss is recognized when an investor sells at a loss.

While we can’t address what specific strategies will be best for you, we can provide general ideas.

Help Protect Gains

With the general up trend in stocks, investors may have positions they would like to sell. They could sell because they believe the stock is overvalued or they may believe the broad stock market is set to sell off.

However, they may not want to take profits now because that could increase the amount of taxes due. There is an options strategy that can help with this problem. That strategy is known as a protective put strategy.

This strategy is used when an investor is worried about a sharp decline in the underlying stock’s price.

To implement a protective put, an investor buys a put option while holding the stock they own. A put option is the right, but not the obligation, to sell a stock at a certain price for a length of time.

Buying the put places a floor under the stock and limits the size of the potential loss. The put will expire worthless if the stock continues to rise or remains above the put exercise price, which is the price the owner of the put has the right to sell at.

Let’s look at an example. Consider Tesla, Inc. (Nasdaq: TSLA), a stock that has nearly doubled this year. Assume you bought at $200 and the stock is now at $350. You might want to preserve at least half of your gain. This means you would sell at $275.

There is a put option expiring in January with an exercise price of $270 trading at about $4. You could buy this put. If TSLA falls below $270, you then have the right to sell your shares at $270. If TSLA remains above that price, the option expires worthless. You lose the amount paid for the option but continue to own TSLA.

Protective puts can be used with any position to protect a large gain or to act as a stop loss that is hidden from market makers and therefore unlikely to be executed at a price well below your desired level.

The risks and rewards of the strategy are shown below. You have unlimited upside potential and you have limited risk with a protective put strategy.

Potentially Defer Some Taxes

Alternatively, you might want to sell those TSLA shares now, at the current market price and lock in the gain. However, you may have other large gains and be in a higher tax bracket so selling now would mean losing a larger percentage of gains to taxes than you would next year.

In this situation, a covered call strategy could be useful. The risk and rewards of this strategy are summarized in the next chart. Here, you see that you have limited potential upside and large risks. The risks can be reduced if your intention is to sell the stock.

Again, we are assuming you are trading TSLA with the stock near $350, about $150 more than you paid for it. The stock is volatile and a move back towards $200 is certainly possible. In fact, a decline to about $275 would be in line with the stock’s current volatility.

We know this because of the value of an indicator known as the average true range (ATR), an indicator that shows the size of the average price move of a stock.

The ATR is simply an average of the true range (TR) and the TR is an indicator developed to correct a problem with the range calculation.

A stock’s price range is defined as the difference below the high and low price for a day. This calculation works fine most of the time but if a stock gaps up or down at the open, the range calculation will miss the volatility at the open. The TR corrects that problem.

The TR is the largest value of three values that need to be calculated each day. Those values are the current high minus the current low; the absolute value of the current high less the previous close; or the absolute value of the current low less the previous close. This includes the effect of gaps.

The ATR is a moving average (MA) of the TR. ATR measures volatility. It will increase in value when the stock’s price move is larger than they have been in the recent past. ATR will decline in value when a stock’s volatility declines and the values of the TRs become smaller.

TSLA’s ATR is about 25.45%. This indicates there is a high likelihood of a price move of that size in any given week. Stocks generally move within a price range of about 3 ATRs. This indicates TSLA could decline to about $275, which is the current price less the value of three times the ATR of $24.50.

Rather than risking the full loss on TSLA, a trader could sell a call expiring in January with an exercise price of $270. This would generate immediate of about $90. That would create income that is taxable this year.

If TSLA is trading above $270 when the option expires in January, the call option allows you to lock in that sales price. You will be able to sell at $270 and realize a gain at that time. Combined, the two transactions deliver a large profit and split the taxes over two years.

Possibly Reduce Taxes

Investors also face decisions with managing losses at this time of this year. Selling creates a taxable capital loss that could be used to offset capital gains created by selling profitable positions. However, an investor may not want to sell a stock at a loss because they believe it has significant potential.

An example could be a retailer like Foot Locker, Inc. (NYSE: FL), a stock that is down about 50% in 2017. FL now trades at about 8 times projected earnings. Shareholders may believe a recovery will come as the retail sector moves higher after worries about online sales ease.

Please note, we are not recommending FL as a buy. We are citing it as an example of this strategy.

If you were holding the stock and have a cost basis near the 52-week high of $75, the loss per share could be about $40, a significant capital loss that could be a benefit for taxes. In this case, you could sell the stock to realize the loss and buy a call to maintain exposure to the stock.

In this case, the loss is limited if FL declines but is unlimited if the stock rallies. This strategy, selling the stock and buying a January call option such as the January $32 call for about $2.50 could be a tax efficient strategy.

These strategies are examples of how options are a versatile tool and could meet many of your trading objectives. These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.